Question

A firm is considering investing in a project that requires an initial investment of $200,000 and is expected to produce cash inflows of $60,000, $80,000, and $100,000 in first, second, and third years. There will be no residual value. The firm applies a discount rate of 10%. Discount factors for Year 1, 2 and 3 are 0.909, 0.826, and 0.751 respectively. Required: i) Calculate the NPV of the project. ii) Explain the meaning of NPV and its advantages as an investment evaluation method compared with the Accounting Rate of Return and Payback methods.

Answer 1

Years	Net Cash Flows	Discount Factor	PV of Cash Flows at 10%
1	60000	0.909	$54,540
2	80000	0.826	$66,080
3	100000	0.751	$75,100
	Total of PV of CashFlows		$1,95,720
	Less:Investment		$2,00,000
	NPV		-$4,280
	NPV is the excess of the present value of Net cash flows over the investment value.
	NPV is better than payback period because the NPV considers both time and dollar values through calculating the PV of cash flows
	Whereas Payback period just considers the time value and shows that how much time is required to recover the Initial Investment.
	Hence NPV is better for making investment decision as compared to Payback period or Accounting rate of return